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Clash of the Titans

When the old USA Waste purchased Waste Management Inc. (WMI), Oak Brook, Ill., earlier this year, it underscored a key principle of the waste management industry: Anybody can be bought.

Then again, the fact that a smaller company bought a bigger company should come as no surprise. Mergers and acquisitions have characterized the waste management industry for 30 years, ever since the old WMI and Browning-Ferris Industries (BFI), Houston, first discovered that growth has two parts: selling new collection accounts and buying accounts in the form of other companies with revenue streams. Trash collectors have been buying each other ever since.

Where will it all stop? How are mergers and acquisitions altering the industry's structure and stability? Is the current buying and selling spree a shake-out that will leave four or five major companies to collect waste across the country? Is this an industry just doomed or blessed to pass through endless cycles of consolidation?

It is difficult to imagine a model of the waste business that explains what drives it to merge and acquire. Most industries begin to consolidate when the market matures or stops growing. At that point, industry players only can grow by buying other companies and their market shares.

The waste industry is different. "Two or three years ago, estimates said the solid waste industry was a $32 billion market," says Peter Ruud, vice president-administration and corporate secretary for Superior Services Inc., Milwaukee. "But today, estimates say the industry has grown to $36 billion and will continue to grow to $50 billion in the next decade."

Trash has been growing for 30 years and promises to continue growing as increasing numbers of people throw out increasing amounts of garbage. Clearly, waste markets have not yet matured, and it is impossible to rely on conventional industry models to understand what is happening.

"Fragmented industries tend to have a lot of consolidation, too," says Richard Ilsley, a partner with the Chicago-based consulting firm of Meridian Sales Development Specialists. "In many fragmented industries, such as the executive placement industry, every company does the same kind of work. So it is relatively easy for a consolidator to integrate other companies into its operation, install uniform operating practices and gain the benefits of higher revenues and lower costs. But it only works if the consolidators are expert operators."

That seems to be what is happening in the waste industry today: Expert operators have become top consolidators. In the late 1960s, executives at BFI and WMI realized they could grow by consolidating a fragmented industry in which the same fundamental operating principles applied to all collection and disposal companies. On the strength of that idea, these two companies roared through the '70s into the '80s until brimming landfills and shortages in disposal capacity brought government policymakers into the picture.

"About 20 years ago, as a country, we began to examine the way we manage solid waste," says Joseph S. Fusco, vice president of communications for Casella Waste Systems Inc., Rutland, Vt. "In the early 1980s, we underwent a massive policy change. The most visible element of this change was the federal Resources Conservation and Recovery Act (RCRA), which passed in the early 1980s and instituted Subtitle D Landfill regulations.

"We went from an environment where every small town had a dump to [one where we had] technically sophisticated, regional landfills," he continues. "We also decided not to throw everything away and to begin to recycle wastes in an organized fashion with engineered material recovery facilities. In other words, we changed from an inexpensive way of managing waste to a process that was very capital intensive, knowledge intensive, technically intensive and management intensive.

"When this happened, many waste management companies and divisions of local governments either were unwilling or unable to make the capital investments necessary to meet those new standards," Fusco says. The result was a second era of waste management industry consolidation led by companies with capital, such as BFI and WMI, and companies that found ways to get capital by going public, such as Chambers, Mid-America and United.

Capital considerations and financial management capabilities drove consolidation activity through the middle and late 1980s, says Henry Hirvela, vice president and chief financial officer of Allied Waste Industries Inc., Scottsdale, Ariz. Consolidators with capital found it possible to take advantage of what Hirvela calls the "supposed" landfill shortage.

"Two large companies, BFI and WMI, also pursued a growth strategy through diversification into other businesses such as hazardous waste and recycling," adds Tod C. Holmes, senior vice president and chief financial officer of Republic Services Inc., Fort Lauderdale, Fla. "Along with those moves came heavy bureaucracies and more centralized management philosophies."

That left the door open for other well-capitalized companies to initiate a third phase of industry mergers and acquisitions by adopting a strategy to become the low-cost provider in particular markets.

"We're going back to that old-time religion," says Allied's Hirvela. "Today's merger and acquisition activity is a back-to-the-basics move led by companies with operating expertise, such as [the former] USA Waste.

"We're part of this group, too," Hirvela continues. "Today's consolidators are characterized by a strong operating culture. We know how to run trucks, collect trash and operate landfills. Operations people are in control, while financial management has become part of the support structure."

Indeed, an Allied market entry generally features a strategy built on an understanding of trash problems and management. For example, in 1992, Allied executives sniffed out a garbage problem in Chicago: Imminent landfill closings would soon force disposal activities outward into the surrounding region. Whatever company owned the regional disposal capacity necessary to Chicago's future would own a large portion of the city's waste management business.

Allied moved quickly and entered the Chicago market by purchasing two landfills, two collection operations and one transfer station in each of these Illinois cities: Chicago, East Moline and Hoopeston.

Next, Allied acquired six Chicago collection companies to feed its new landfills, tucking each company into its Chicago operation.

Since entering the Chicago market in 1992, Allied has acquired 32 collection companies, eight transfer stations and four landfills. The company also has developed two additional landfills, accessible from Chicago in northwest Indiana, which have enhanced the company's disposal capabilities in that state.

Targeting Rational Operations The Allied example applies the principles important to successful waste management consolidation in the late 1990s: Waste management consolidation is more than buying the revenues of individual companies.

To make everything work out for the long term, a company must buy a rational operating system. Revenue streams from collection operations are important but may have little real value if, for example, it costs too much to dispose of the trash. A rational operating system includes a source of revenue from collections, plus a low-cost means of disposal.

Allied has proven to be one of the most disciplined practitioners of this art, having organized the markets it has purchased in a way that has produced an internalization rate of more than 70 percent.

With variations on this theme, today's major consolidators, including Allied, Republic Services, Milwaukee-based Superior Services, Raleigh, N.C.-based Waste Industries and the new WMI (which continues to consolidate with its recent purchase of Eastern Environmental Services, Mt. Laurel, N.J.) are transforming the consolidation process from something akin to a financial roulette game into a business based on rationally conceived operating markets.

Two other consolidators, Casella Waste Systems and Roseville, Calif.-based Waste Connections Inc. have moved this strategy out of the metropolitan regions into suburban and rural communities. Both have applied the model of purchasing rational operating markets to the special management problems created by small, spread-out population centers.

Lonnie Poole, Waste Industries' chief executive officer, notes another important wrinkle in today's consolidation market. "In the past, most companies were growing primarily through mergers and acquisitions," he says. "They really didn't give much consideration to selling any of their operations. What we see today are net buyers and net sellers. Some are selling operations that they no longer want or need. At the same time, they are acquiring operations they do need. This is a major shift in how consolidation is occurring."

The Never-Ending Story? Rational or not, all consolidation movements have limits. Where will this phase of industry consolidation end?

If the total current waste management market amounts to operations worth $36 billion, representatives of the different consolidating companies say that the available acquisition targets comprise a pool of companies worth between $8 billion and $12 billion. The remainder of the market consists of private companies that may or may not sell and of municipal or regional authorities that exhibit little interest in privatizing.

"Consolidation has an end-game," says Ronald Mittelstaedt, president and chief executive officer of Waste Connections. "If you think of it as a football game, I would say that the game is in the middle of the third quarter for most urban markets. In the rural and suburban markets, where we operate, I don't think it's half-time yet."

Republic Services' Holmes holds a different view. "I think this is more of a continual cycle," he says. "There always will be another game or another season, with new, small, private companies entering the market and finding a low-cost niche.

"Whether there are $8 billion or $12 billion in private companies out there right now, the total never will go down to zero, because the market always will replenish itself," Holmes continues.

What will change, and indeed has changed in the current market, according to Holmes, is the size of the individual acquisition targets. Companies with revenues of $100 million and $200 million are disappearing from the market, leaving companies with $20 million to $40 million in revenues as the current targets.

Another factor influencing the length of the consolidation game involves the privatization market's potential. While some municipalities and operating authorities seem prone to privatization, others prefer to run their own operations - at least for the time being. But that could change. "Many local governments across the country are asking whether they want to put taxpayers' money at risk by running a highly competitive business in which they have no particular expertise," says Casella's Fusco.

Perhaps this trend will grow, leading to more consolidation opportunities. "Right now, not a lot of local governments think this way, and not a lot of companies think this way," Fusco continues. "Still, there is a lot of self-examination going on."

The Stock Market's Wild Ride While solid waste market factors may extend the current era of waste industry consolidation, other factors may change the rules of the game and the companies involved.

For example, the stock market fell by nearly 20 percent between summer and fall of this year. No one knows what will happen next. "To the extent that you do stock deals, multiple contractions in the price of your stock will dampen your appetite to use stock in acquiring other companies," says Allied's Hirvela. Holmes of Republic Services believes that price-to-earnings multiples prices will determine how stock market volatility will affect mergers and acquisitions in the coming months. "If you have a high multiple, say 40, and you are acquiring someone with a lower multiple, your stock is cheap currency," he says. "That's the game of pooling."

As stock prices fall, so do price-to-earnings multiples. For a buyer using stock, a transaction suddenly appears more expensive. For a seller, a stock offer suddenly looks less valuable.

"This kind of stock market volatility could make sellers turn to cash," says Holmes - a development that would suit Republic, given its high cash reserves and policy of acquiring companies for cash. While the stock market has created issues about the relative values of stock and cash in the acquisition process, the Securities and Exchange Commission (SEC) reportedly is considering a policy change that would eliminate pooled accounting acquisitions.

The pooled accounting method differs from purchase acquisition in which cash serves as the transaction currency. Under purchase accounting, the amount of the purchase price over fair market value must show up on the balance sheet as good will.

In the world of trash, good will accounts for as much as 80 percent to 90 percent of the purchase price of a company. So it seems that changing from pooling to purchasing might affect the merger and acquisition landscape. "If you believe that earnings per share drive stock prices, then a change from pooling to purchasing would dampen your acquisition activity because higher stock multiples produce better earnings per share results in an acquisition," says Allied's Hirvela. "But if cash flow is all important to you, it won't matter what method you use because there is no impact on cash flow."

Hirvela thinks that an SEC change mandating purchase accounting will level the playing field. Such a change will make reported earnings appear to be lower. But everyone will have the same problem. "It may make it harder for smaller growth companies with high multiples," Hirvela says. "But eventually, life will go on."

Over the long haul, which in this industry may be two or three years, merger and acquisition momentum will continue to consolidate the consolidators. "In some urban markets, WMI has consolidated the entire public company marketplace," says Waste Connections' Mittelstaedt. "Eighteen months ago, there were nine companies where now there is one. In the overall market, the number of consolidator companies is down to eight. I think by the year 2000, the number will be down to four or five." Mittelstaedt won't speculate as to which four or five consolidators will be left standing. Who would? Because after all, the truth is that anyone can be bought.